Policy of Choice

As the market awaits the BOE’s rate decision this morning, the dollar has edged lower amid muted activity. Last night the Minutes of the BOJ’s April policy meeting were released and it should be no surprise that the commentary focused on the need to maintain their current monetary ease in order to achieve their inflation target. You may recall that at the April meeting, they discarded the timeline for achieving their goal, and now are simply trying to get there as quickly as they can. Of course, it has been more than five years since Kuroda-san was first appointed and expanded the BOJ’s asset purchase program in an effort to eliminate the deflationary spiral that had come to dominate the Japanese economy. And they haven’t come close to being successful yet.

I’m not sure how many of you remember the ‘Misery index’, a term coined by economist Arthur Okun in the 1970’s and effectively used by then presidential candidate Ronald Reagan in 1979, which was simply the sum of the inflation and unemployment rates. The idea was to show just how bad things were in the US economy back then, and in fact, that was the height of the stagflation era and the index was around 20%. In the US today that number is ~6.0% depending on which measure of inflation you use. In Japan, that number is 3.6%! My point is that things in Japan are hardly dire despite all the angst at the BOJ. I’m not saying that the debt situation there is sustainable, merely that the ongoing conversation regarding the horror over the lack of inflation seems to be misplaced. It remains extraordinary to me that central bankers the world over are so focused on driving inflation higher. Inflation is a problem in Argentina, running at 40%. Inflation running at 1% in Japan seems pretty manageable. (In fairness, higher inflation would reduce the real value of Japan’s massive debt load, so I do understand that rationale. But that doesn’t help the man on the street!) The yen did little in response to the Minutes, although it has definitely been under pressure for the past several sessions. However, that may well be more a result of general dollar strength than specific yen weakness.

Moving on there are two key stories for the rest of the day. First is the aforementioned BOE rate decision. A month ago, the market had been pricing upwards of a 90% chance of a 25bp rate hike today. Now that number stands below 10%. In the interim, we have seen both less hawkish commentary from several BOE members, notably Governor Carney when he reminded everyone that there was more than one opportunity for the BOE to raise rates this year if they had to. And shortly thereafter, Q1 GDP printed at just 0.1%, significantly lower than expected. Meanwhile, the most recent CPI data fell to 2.5%, below expectations and seeming to be trending lower. Add it all up, and there seems little reason for the BOE to get aggressive here. During the past month, the pound has fallen some 5% and the market is now awaiting the next BOE signals. Any further dovishness, which could be signaled by a unanimous vote to remain on hold, could easily lead to another 1%-2% decline, although if there are more than the 2 votes to raise rates we have seen the past several meetings, the market would likely interpret that as hawkish, and the pound should add to this morning’s rebound of 0.45%

The other data point of note this morning is CPI from the US. Current expectations are for CPI to rise 0.3% (2.5% Y/Y) with the ex food & energy number to be 0.2% (2.2% Y/Y). I continue to believe the risk is for a higher print and the reaction would be for the dollar to resume its rally. Whether or not you believe that the Fed is mistaken to be tightening so aggressively, it seems clear to me that Chairman Powell is on a mission and is going to keep going for the rest of the year at least. And while one of my concerns is that a recession in the US could be coming sooner than most pundits expect, there is no obvious sign that it is imminent, and so the Fed will keep going. Despite the fact that the Fed uses PCE in their models, they are not blind to the recent swift rise in CPI.

Other than that, and unless we get some new information from unexpected places (read the White House), it feels like the dollar, which has softened somewhat overnight, is likely to rebound a bit. Treasury yields continue to support the greenback, and interestingly, the rally in oil prices has had very little impact. One of the things people point to regarding oil is that there is a strong negative correlation between oil and the dollar. My question is which way is the causality? It is not clear to me that oil drives the dollar, nor that the dollar drives oil. And it is very possible that the causality changes over time, although the correlation has remained pretty consistent. In fact, the recent simultaneous strength of the two is the outlier. In the end, I’m not prepared to opine on whether continued oil price strength will weaken the dollar’s support. But my gut tells me that right now, the two are trading on different issues, and so are somewhat independent. If that is the case, then be prepared for the dollar to continue its ascent even if oil heads toward $80/bbl.